Chapter 11-Behaviour of the markets Flashcards
- Explain how the risk vs return impacts a particular asset class over the short and long term.
At the highest level, asset classes with the greatest risk also have the potential for the greatest return over the long term. However, price fluctuations can depress values in the short term.
- What is the main way the government can finance the fiscal deficit and explain how this is achieved?
Issuing government bonds is the main way governments finance the fiscal deficit. The demands of purchasers can influence the terms on which debt is issued.
- What four risks do corporate bonds expose investors to?
Corporate bonds expose investors to default, inflation, marketability and liquidity risk.
- Describe how these risks are allowed for in the price.
The premiums for accepting these risks are factored into the market price of the bonds - in particular the spread, which is the difference between the yield on a corporate bond compared with the equivalent government bond.
- Outline how the corporate bond market can help financial product providers match their asset and liabilities.
Financial product providers who need to match asset proceeds to a stream of benefit outgo can structure a portfolio of bonds so that the assets can all be held to maturity.
- Give an example of contagion risk in relation to equity markets.
For example, an event in the USA that causes US equity markets to fall is very likely to trigger immediate falls in other worldwide equity markets. This is despite the triggering event having no direct impact in other countries.
- Outline a regulatory requirement for financial product providers who offer guarantees.
Financial products generally offer guarantees and to ensure customers are not disadvantaged, regulators require providers to hold capital against guarantees. If product guarantees are covered by guaranteed returns from assets held, the amount of capital earmarked against the product guarantees is reduced.
- Discuss the extent to which a product provider chooses to match its assets to its guarantees.
The extent to which a product provider chooses to match its assets to its product guarantees or to depart from a matched position in the hope of achieving better returns and higher profits will depend on the provider’s risk appetite - which in turn is driven by the free capital it has available.
- What determines the level of prices for an asset class?
The general level of all markets is determined by the interaction of buyers and sellers. As demand for an asset type rises, then the general level of the market in that asset type will rise. If demand falls, then prices will fall. Demand for most investments is very price elastic because of the existence of close substitutes. The main factor affecting demand is investors’ expectations for the level and riskiness of returns on an asset type.
- What are the main factors affecting short-term interest rates?
Short-term interest rates are largely controlled by the government through the central bank’s intervention in the money market. The government sets interest rates, directly or indirectly, in an attempt to meet its (often conflicting) policy objectives.
- Describe the economic effects of low short-term interest rates.
Low real interest rates encourage investment spending by firms and increase the level of consumer spending. So cutting interest rates increases the rate of growth in the short term.
If interest rates in one country are low, relative to other countries, international investors will be less inclined to deposit money in that country. This decreases demand for the domestic currency and tends to decrease the exchange rate.
- Explain how quantitative easing works.
QE works as follows:
* The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market.
* This purchase of assets directly increases the supply of money in the financial system, which encourages banks to lend more and can push interest rates lower.
* The purchase of assets can also reduce the returns on money market assets and bonds, reducing the appeal of those asset types.
Lower interest rates also reduce the cost of borrowing for businesses and households. If businesses use the money to invest and consumers spend more, this can boost the economy.
Stock markets therefore typically respond to news of quantitative easing, with stock markets tending to rise when the central bank announces increased quantitative easing and fall when the central bank announces a contraction in quantitative easing.
- Outline the concept behind the ‘quantity theory of money’ and how this is used to manage inflation.
The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services in that economy. According to this theory, if the amount of money in an economy were to double, then price levels would also double, causing inflation. A consumer would have to pay twice as much for the same good or service.
- Describe the following theories used to explain the shape of the yield curve:
(1) Expectations theory
(2) Liquidity preference theory
(3) Inflation risk premium theory
(4) Market segmentation theory
(1) Expectations theory
Expectations theory describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for future short-term interest rates.
If we expect future short-term interest rates to fall (rise), then we would expect gross redemption yields to fall (rise) and the yield curve to slope downwards (upwards).
(2) Liquidity preference theory
The liquidity preference theory is based on the generally accepted belief that investors prefer liquid assets to illiquid ones. Investors require a greater return to encourage them to commit funds for a longer period. Long-dated stocks are less liquid than short-dated stocks, so yields should be higher for long-dated stocks.
According to liquidity preference theory, the yield curve should have a slope greater than that predicted by the pure expectations theory.
(3) Inflation risk premium theory
Under the inflation risk premium theory the yield curve will tend to slope upwards because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than shorter-dated stocks.
(4) Market segmentation theory
Market segmentation (or preferred habitat) theory says that yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
Demand for short bonds comes from banks, which compare their yields with short-term interest rate. Demand for long bonds comes from pension funds and life assurance companies that have long-term liabilities.
The supply of bonds of different terms will reflect the needs of borrowers. For example the government may issue short-term bonds if it has a short-term need for cashflow.
The two areas of the bond market may move independently.
- What is the real yield curve?
This is the curve of real yields on index-linked bonds against term to maturity.
- What factors influence the shape of the real yield curve?
The real yield curve, like the conventional yield curve, is determined by the forces of supply and demand at each maturity duration. Thus, it can be viewed as being determined by investors’ views on future real yields modified according to market segmentation theory and liquidity preference theory. The government’s funding policy will also influence the shape of the curve.
- Describe factors that affect the level of bond yields
- Inflation expectations: Inflation erodes the real value of income and capital payments on fixed coupon bonds. Expectations of a higher rate of inflation are likely to lead to higher bond yields and vice versa.
- Inflation uncertainty: Additionally, uncertainty about the level of future inflation will affect conventional bond yields. The higher the uncertainty, the higher the inflation risk premium.
- Short-term interest rates: The yields on short-term bonds are closely related to returns on money market instruments so a reduction in short-term interest rates will almost certainly boost prices of short bonds. However, investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. So the yield on long bonds might decline by a smaller amount, or even rise.
- Fiscal deficit: If the government’s fiscal deficit is funded by borrowing, the greater supply of bonds is likely to put upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding. Selling Treasury bills would increase short-term interest rates, while printing money will lower rates but increase expectations of inflation.
- Exchange rate: A significant part of the demand for government bonds in many markets comes from overseas. Changes in expectations of future movements in the exchange rate will affect the demand from overseas investors. It will also alter the relative attractiveness of domestic and overseas bonds for local investors.
- Institutional cashflow: The demand for bonds can be affected by institutional cashflow. If institutions have an inflow of funds because of increased levels of savings they are likely to increase their demand for bonds. Changes in regulation and investment philosophy can also affect institutional demand for bonds.
- Other economic factors: Almost any piece of economic news has implications for inflation and short-term interest rates. The impact of other economic factors can therefore usually be understood in terms of these two quantities.
- Returns on alternative investments
- What factors affect the yields on corporate bonds relative to those on government bonds?
Economic factors which adversely affect prospects for corporate profitability are likely to increase the perceived risk of corporate bonds relative to government bonds. This will increase the general level of the yield margin of corporate over government debt.
- Explain how the availability and price of government debt might affect the actions of otherwise risk-averse investors.
For example, if government debt was offering very poor returns compared with high quality corporate debt, some investors may weaken their normal risk profile to secure the extra return. This would tend to narrow the gap between corporate and government debt.
- Explain how supply side issues may influence corporate debt yields.
Supply side issues also have an impact. If equity market conditions are depressed, companies may find it easier to raise funds through issues of corporate debt than through equity issues. Oversupply of corporate debt reduces prices and increases yields.
- What factors affect the level of the equity market?
It is investors’ expectations of future corporate profitability and the value of those profits which largely determines the general level of the equity market. Amongst the main factors that influence the general level of the equity market are:
* expectations of real interest rates and inflation
* investors’ perceptions of the riskiness of equity investment
* the real level of economic growth in the economy.
In addition to the factors listed above, any factor affecting supply (eg the number of rights issues, share buy-backs, or privatisations) and any factor affecting demand (eg changes to tax rules, institutional flow of funds, and the attractiveness of alternative investments) will affect market prices.
- Describe the influence of short-term interest rates and inflation on the equity and bond market.
Equity markets should be reasonably indifferent towards high nominal interest rates and high inflation. If the rate of inflation is high, the rate of dividend growth would be expected to increase in line with the return demanded by investors.
It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices.
Real interest rates are probably more important than nominal interest rates. Investors expecting high inflation may also expect the government to increase nominal interest rates in response.
Low real interest rates should help to stimulate economic activity, increase the level of corporate profitability, and hence raise the general level of the equity market. Also, the rate of return required by investors should be lower, so the present value of the future dividends will be higher.
Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Nervousness in the bond market might result in an increase in equity investment, as equities should provide a hedge against inflation. This would tend to increase the relative level of the equity market at the expense of the bond market.
- Describe the equity risk premium.
The equity risk premium is the additional return that investors require from equity investment to compensate for the risks relative to risk-free rates of return.
The equity risk premium fluctuates from time to time, depending on the overall level of confidence of investors and their views on risk.
- Describe the link between real economic growth and the level of the equity market.
In general, real dividends, and therefore the fundamental value of companies, would be expected to grow roughly in line with real economic growth. Therefore changes in investors’ views on economic growth have a major effect on the level of the equity market.
